Rev. Rul. 89-3

1989-1 C.B. 278, 1989-2 I.R.B. 5.

                       Internal Revenue Service

                                 Revenue Ruling

                    TERMINATION; TRANSFER; RECAPITALIZATION

                           Published: January 9, 1989

SECTION 2612. - TAXABLE TERMINATION; TAXABLE DISTRIBUTION; DIRECT SKIP

(Also Sections 354, 368, 2501, 2601; 1.354-1, 1.368-2, 25.2501-1, 26.2601-1.)

  Termination; transfer; recapitalization. A donor has made a transfer subject to gift tax and an addition to trust corpus for generation-skipping transfer tax purposes, where, pursuant to a plan of recapitalization, the donor exchanges voting common stock for stock with voting rights that terminate at the donor's death, and the balance of the outstanding stock is held by a generation-skipping trust.

  An individual created an irrevocable generation-skipping trust in 1982 and provided funding with a transfer of 100 shares of common stock in a corporation; these shares had a value of $500x. The settlor kept the corporation's remaining 800 shares of common stock.

  In 1987, the corporation underwent a section 368(a)(1)(E) recapitalization. The corporation issued the settlor 800 shares of class B common stock in exchange for the settlor's 800 shares of common stock. The new stock had the same rights as the old, except that upon the settlor's death, the voting rights of the class B common stock would be extinguished. The trust's 100 shares of voting common stock were exchanged for 100 shares of class A voting common stock. The new class A stock had the same rights as the old common stock. Immediately prior to the recapitalization, the trust's 100 shares of common stock had a value of $900x. The recapitalization diminished the value of the settlor's stock, and increased the value of the trust's stock, by $100x.

  ISSUES. At issue is (1) whether the recapitalization caused a taxable gift from the settlor to the trust beneficiaries and (2) whether an addition to the corpus of the trust has been made for purposes of the generation-skipping transfer tax.

  HOLDINGS. The Service has held that the recapitalization caused a taxable gift from the settlor to the trust beneficiaries and caused an addition to the corpus of the trust for purposes of the generation-skipping transfer tax.

  ANALYSIS. Citing Rev. Rul. 86-39, 1986-1 C.B. 300, which dealt with a shift in control of a closely held corporation, the Service concluded that the section 368(a)(1)(E) recapitalization gave rise to a taxable gift of $100x, the amount by which the trust's stock holdings were increased in value.

  Turning to the generation-skipping transfer issue, the Service worked its way through section 2612 and the amendments made by the Tax Reform Act of 1986, which apply to transfers out of corpus added to the trust after September 25, 1985. The Service concluded that the increase in value of the trust's stock holdings from $500x to $900x did not constitute an addition to trust corpus since it was attributable to 'ordinary appreciation.' The reorganization, however, did increase the trust's corpus, and did occur after the 1986 Act amendments' effective date. Accordingly, the Service said, 'when the trust terminates upon the death of [the settlor's child], that portion of the trust corpus distributable to [the settlor's grandchild], a skip person, that is allocable to the addition to the trust will be subject to the tax on generation-skipping transfers.'

ISSUE

  If a recapitalization that qualifies under section 368(a)(1)(E) of the Internal Revenue Code increases the value of the stock held by a trust and reduces the value of the stock held by a controlling shareholder, who is the original grantor of the trust, has a gift been made to the trust beneficiaries for federal gift tax purposes and has an addition to the corpus of the trust been made for purposes of the federal generation-skipping transfer tax?

FACTS

  G created an irrevocable generation-skipping trust in 1982 and funded the trust by transferring to it 100 voting common shares of X Corporation stock. G retained the balance of X Corporation stock, which consisted of 800 voting common shares. At the time of the 1982 funding, the 100 shares transferred to the trust had a value of 500x dollars. The trust instrument provides that income is payable G's child, C, for life and that only upon C's death is the trust corpus distributable to G's grandchild, D.

  In November, 1987, pursuant to a plan of recapitalization, X Corporation issued 800 shares of a new class of B voting common stock to G in exchange for G's 800 shares of regular voting common stock. The Class B common stock had all of the same rights as the stock previously held by G except that, upon the death of G, the voting rights of the Class B common stock would be extinguished. The 100 shares of common stock held by the trust were exchanged for 100 shares of new Class A regular voting common stock. None of the rights of the stock held by the trust was altered. Immediately prior to the recapitalization, the 100 common shares held by the trust had a value of 900x dollars. The recapitalization of X Corporation diminished the value of the stock held by G and increased the value of the stock held by the trust by 100x dollars. Thus, after the recapitalization the stock held by the trust had a value of 1000x dollars. The recapitalization of X Corporation is described in section 368(a)(1)(E) of the Code, and the exchange of common stock for common stock resulted in no recognition of gain or loss to G or to the trust under section 354(a).

LAW AND ANALYSIS

  Section 2501(a)(1) of the Code imposes a tax for each calendar year on the transfer of property by gift. Section 2511 applies the gift tax to transfers that are in trust or otherwise, whether the gift is direct or indirect, and whether the property is real or personal, tangible or intangible. All transactions whereby property or property rights or interests are gratuitously passed or conferred upon another, regardless of the means or device employed, constitute gifts subject to tax. Section 25.2511-1(c) of the Gift Tax Regulations. However, the gift tax generally is not applicable to transfers for full and adequate consideration in money or money's worth or to transactions at arm's length in the ordinary course of business.

  Rev. Rul. 86-39, 1986-1 C.B. 300, described the tax consequences of an acquiescence by a beneficiary of a trust in the recapitalization of a closely- held corporation. The trust owned stock of the corporation and the beneficiary possessed a general power of appointment over the assets of the trust. Because the recapitalization shifted value from stock held by the trust to stock held by another shareholder, the ruling held that the shift resulted in a transfer for federal gift tax purposes.

  Section 2601 of the Code imposes a tax on generation-skipping transfers. Section 2611(a) defines a 'generation-skipping transfer' to mean a taxable termination, a taxable distribution, or a direct skip.

  Section 2612(a) of the Code defines a 'taxable termination' to mean the termination (by death, lapse of time, release of a power, or otherwise) of an interest in property held in a trust unless (a) immediately after such termination, someone other than a skip person has an interest in such property, or (b) at no time after such termination may a distribution (including a distribution on termination) be made from such trust to a skip person. A 'skip person' is defined by section 2613 to include a person assigned to a generation that is two or more generations below the generation assignment of the transferor, as well as a trust if all interests in such trust are held by skip persons.

  Section 2612(b) of the Code provides that a taxable distribution is defined as any distribution from a trust to a skip person except for a taxable termination or a direct skip.

  Section 2612(c) of the Code provides that a direct skip is defined as a transfer of an interest in property to a skip person that is subject to either the gift or estate tax.

  Under the definition in section 2652(c)(1) of the Code, an individual has an interest in property held in trust if the individual has a right (other than a future right) to receive income or corpus from the trust or is a permissible current recipient of income or corpus from the trust.

  Section 1433(b)(2)(A) of the Tax Reform Act of 1986 provides that the amendments made to the generation-skipping transfer tax by the Act do no apply to any transfers from a trust that was irrevocable on September 25, 1985, but only to the extent that such transfers are not made out of corpus added to the trust after September 25, 1985. If an addition to the corpus of an irrevocable trust is made after September 25, 1985, a proportionate amount of any future distribution from, or termination of, interests in property held in the trust is subject to the generation-skipping transfer tax when the distribution of termination occurs.

  Under the effective date rules for the generation-skipping transfer tax, generation-skipping transfers from G's trust, which was irrevocable in 1982, are exempt from the tax on generation-skipping transfers to the extent such transfers are not attributable to additions to the trust corpus after September 25, 1985. In general, ordinary appreciation in the value of the corpus of a trust and undistributed income added thereto will not be considered to be an addition to the corpus of a trust.

  In this case the recapitalization of X Corporation caused an increase of 100x dollars in the value of the stock held by the trust for the benefit of C and D. Thus, G made an aggregate gift in the amount of 100x dollars to C and D. See Rev. Rul. 86-39, cited above, at 301.

  Additionally, because G made a gift to the beneficiaries of a generation- skipping trust, the increase in value of 100x dollars constitutes an addition to the corpus of an irrevocable trust for purposes of applying the tax on generation-skipping transfers. The increase in value is treated as a transfer in trust (and is not an increase caused by ordinary appreciation). This transfer generates no generation-skipping transfer tax liability when made because C, who is not a skip person, has an interest in the trust, and D, who is a skip person, does not have an interest in property in the trust within the meaning of section 2652(c)(1) of the Code.

  Accordingly, when the trust terminates upon the death of C, that portion of the trust corpus distributable to D, a skip person, that is allocable to the addition to the corpus of the trust will be subject to the tax on generation-skipping transfers. See section 26.2601-1(b)(1)(iv) of the Temporary Generation-skipping Transfer Tax Regulations for the rules describing the taxation of additions to irrevocable trusts.

HOLDING

  The recapitalization of X Corporation results, for federal gift tax purposes, in a taxable gift by G to the beneficiaries of the trust and constitutes an addition to the corpus of an irrevocable trust for purposes of the generation- skipping transfer tax because the recapitalization reduces the value of the stock held by G and increases the value of the stock held by the trust. This ruling does not address any issues regarding the application of section 2036(c) of the Code to property transfers occurring after December 17, 1987. No inference is intended by this ruling as to the application of section 2036(c) to recapitalizations occurring after December 17, 1987.

DRAFTING INFORMATION

  The principal author of this revenue ruling is Richard Grosgebauer of the Office of Passthroughs and Special Industries. For further information regarding this revenue ruling contact Mr. Grosgebauer on (202) 535-9508 (not a toll-free call).

Rev. Rul. 89-3, 1989-1 C.B. 278, 1989-2 I.R.B. 5.